Let me be clear – I don’t think tax rates will go down soon.
But, I think it’s an important exercise to consider the other side of your beliefs. What if tax rates go down?
I feel confident tax rates will go higher in my lifetime, but what if they don’t? How would that impact the planning I am doing today?
Many people I meet are very set in their ways and beliefs. They only see one possible scenario, which is foolish. In life, almost anything can happen.
The clearest memory I have of this in finance is the belief that interest rates were going to go higher between 2010 and 2020. While they did go higher starting in late 2015, they started to go down again in 2019.
People who decided not to own bonds or thought long-term bonds were a dumb investment were proven wrong.
Interest rates stayed flat or went down when many people thought they could only go up. Although I thought interest rates would go up at some point, I often asked people, “what if they go down?” I then followed up with “we don’t know what is going to happen with interest rates.”
Whenever it comes to the economy or investing, nothing is a foregone conclusion.
With tax rates near historical lows, it’s easy to surmise that they will rise in the future, but what if they don’t? Or, what if they don’t soon?
I’m going to cover how our income taxation works, tax rates today vs. historical tax rates, and what sort of planning you might do if tax rates were going down.
How Income Taxes Work
Our tax bracket system is progressive, meaning, as you make more money, the additional income is taxed at higher rates – not your entire income.
For example, if someone says they are in the 24% tax bracket, that does not mean that all of their income is taxed at 24%.
In reality, only some of their income is taxed at 24%. Some of it is also taxed at 12%, 22%, and 24%.
For example, if someone were a single filer, the first $10,275 of income is taxed at 10%.
From $10,276 to $41,775, they would pay 12%. Between $41,776 and $89,075, they would pay 22%. Finally, they would pay 24% for any taxable income between $89,076 and $170,050.
This is what is meant by progressive. Each additional dollar within the bracket gets taxed at that rate, but income before that bracket is taxed at a lower rate.
When someone says they are in the 24% tax bracket, they are referring to their marginal tax bracket. Their average or effective tax rate is lower. Their average or effective tax rate is calculated by dividing their total tax paid by their total income.
For example, if someone had a taxable income to the top of the 24% tax bracket as a single filer, their average or effective tax rate would be about 20%. That’s calculated by adding up the taxes within each bracket ($34,647.50) and dividing by $170,050.
In reality, their effective rate would be a little lower because their gross income would be higher. I’m referring to taxable income above, which is what is left over after subtracting the standard deduction or itemized deductions, if eligible.
I’ve simplified to highlight the point that our tax brackets are progressive and as you earn more income, you may find yourself in a higher marginal tax bracket with each dollar of income being taxed at a higher rate – but not the previous income.
Tax Rates Today vs. Historical Tax Rates
If you want to take a trip back in time, you can see historical tax rates going back to 1862. It may not be the most useful because it is listed in nominal dollars as opposed to in today’s dollars, but it is fascinating to see tax rates of 3% on up to $600 of income and 5% on amounts above $10,000.
What you will find in the tables is how low our tax rates are today compared to what they have been in the past.
You’ll also notice tax rates can change – quite dramatically, quite quickly.
From 1916 to 1917, the top tax rate went from 15% to 67% on taxable income above $2,000,000. I’m guessing there weren’t too many people with taxable incomes above $2,000,000 during those years, but it gives you an idea of how quickly tax rates change.
By 1918, the top tax rate was 77% on taxable income above $1,000,000.
Fast forward a few years and in 1925, the top tax rate was 25% on taxable income above $100,000.
By 1932, the top tax rate was 63% on taxable income above $1,000,000. Then, in 1936, the top tax rate was 79% on taxable income above $5,000,000.
In 1944, the top tax rate was a whopping 94% on taxable income above $200,000! That is equivalent to about $2 million dollars in today’s dollars.
War is expensive. Taxes were a way to help pay for it.
Imagine the difference in taxes you would pay for your next $100,000 in earnings if you were subject to the top tax rate. In some years, it was $15,000 and in others, it was $94,000.
Although the top tax rate was astronomically high at times, the truth is that most people never paid taxes at the top tax rate. You can see in the chart below that the top 1% of US households never paid an average tax rate of more than 46%.
The reasons for this can’t be known for certain, but one logical argument is that top tax rates don’t affect most people, and plenty of income is still taxed at lower rates. It’s estimated that only 10,000 families were earning enough income to be affected by the top tax rates when they were around 90%. Another reason is that as tax rates go up, people work harder to avoid (and often cheat) paying taxes.
If I told you that you would be taxed $22 on your next $100 of income, you might be annoyed, but you probably wouldn’t go too far out of your way to try to reduce it or break a law.
If I told you that you would be taxed $35 on your next $100 of income, you might work a little harder to reduce your taxes. Perhaps you would pay someone (i.e. an accountant) $5 to help you avoid such a high tax and even with that fee, you would come out ahead.
Now, if I told you that you would be taxed $94 on your next $100 of income, you likely are going to work as hard as possible to reduce the tax. Many people would likely fail to report it or find other ways to cheat.
The more incentives you give, negative or positive, the more creative people become.
If you are interested in learning more about our tax system compared to the rest of the world, I highly recommend the book A Fine Mess: A Global Quest for a Simpler, Fairer, and More Efficient Tax System. It talks more about how a flatter tax applied to more income might be a more fair and easy way to restructure the tax code.
Instead of focusing on the top 1% of US households, we can also look at the average tax rate for everyone and the bottom 50%. This chart shows average tax rates including federal, state, and local taxes – not just federal taxes as I am discussing in most of this article. See the chart below:
You can see the average tax rate has gone up over time, but if we look at tax rates over the last few decades using actual tax brackets, we are at historical lows.
People can earn more income right now and pay less in taxes than they have for many decades.
But, as we have seen in the past, tax rates can change quickly.
Although I don’t think it’s going to happen, almost anything is possible. What if tax rates go down?
Planning – What to Do if Tax Rates Go Down?
I’ve personally been planning for tax rates to go up, but let’s go through a thought exercise and flip the planning on its head. Let’s talk about what financial planning you should do if you want to hedge against lower tax rates.
If you anticipate tax rates going down, you want to recognize less income today in order to recognize it in the future. This favors Traditional 401(k) contributions over Roth 401(k) contributions because, with a Traditional 401(k) contribution, you get a tax deduction today. With a Roth 401(k), you pay the tax today, but then it grows tax-free and distributions are tax-free after age 59 ½.
For example, if you are in the 24% tax bracket today, but think tax rates will go down to 15% for you, that might be a reason to contribute more to a Traditional 401(k) instead of a Roth 401(k).
With a Traditional 401(k), you get the tax deduction today. In this example, the deduction would be at the 24% level, meaning if you contributed $10,000 to a Traditional 401(k), you would reduce your tax burden by approximately $2,400.
Fast forward to when your tax rate is 15%, you could now convert money from your Traditional 401(k) to your Roth 401(k) (if your plan allows it). If you converted the same $10,000, you would pay approximately $1,500 in taxes.
You saved $2,400 in taxes and then spent $1,500 in taxes. That’s a great deal!
Overall, you saved $900 using strategic tax planning.
The decision to contribute to a Traditional 401(k) instead of a Roth 401(k) is not straightforward since we don’t know how tax rates will change. Some people also split their contributions 25/75, 50/50, or 75/25 (or any other mix) between a Traditional 401(k) and a Roth 401(k). By doing this, they are diversifying their tax buckets and potentially can better manage distributions in retirement to optimize taxes.
If you anticipate tax rates will go down, you want to accelerate giving because you may receive a higher tax deduction today.
Using the same 24% and 15% tax rates above, if you want to give $10,000 to charity and benefit from itemizing deductions, you would much rather receive a $2,400 reduction in taxes today rather than a $1,500 reduction in taxes in the future.
This strategy only works if you itemize deductions and since the standard deduction is high, many people find they can’t itemize deductions. Please keep that in mind.
Tax-loss harvesting is one of those tax strategies where you want to realize the losses as they occur.
If an investment goes down in value in a taxable brokerage account, you can sell the position, realize the loss, and as long as you don’t rebuy it for 31 days (to avoid the wash sale rule), you can reduce your taxes.
Up to $3,000 per year can offset ordinary income after short-term and long-term capital gains are offset. In the example before, if you realized $3,000 of losses and had no capital gains, you could reduce your tax burden by $720 at the 24% tax rate.
Any amounts above $3,000 are carried forward to future years to offset capital gains first and then up to $3,000 of ordinary income per year.
With tax-loss harvesting, you generally don’t want to wait because you never know when the loss will disappear. Markets move quickly and a loss you have today may not be there next week, let alone a few years from now.
In other words, tax rates changing matter less for tax-loss harvesting.
If you anticipate tax rates going down, you may want to wait on Roth conversions. If you will pay 24% today to move money from a pre-tax account, such as an IRA, to a tax-free account, such as a Roth IRA, and you could pay 15% in the future, you may want to wait until you can pay 15%.
If you convert $10,000 at 24%, that is $2,400 of additional tax when you could have waited until you are in the 15% tax bracket and pay $1,500 of additional tax.
In summary, accelerate deductions, such as charitable giving, and defer income as much as possible if you anticipate tax rates will go down.
Summary – Final Thoughts
Taxes are complicated, and it’s impossible to know what tax rates will be a year from now or decades from now.
Looking at them historically, we are in a relatively low tax rate environment. Personally, I think we will see higher tax rates in the future, but it’s worth thinking about the opposite.
What if tax rates go down?
That flips the planning on it’s head. That would mean deferring income, such as making contributions to a Traditional 401(k), or accelerating deductions, such as charitable giving.
Or, perhaps you hedge your bets and split contributions to a Traditional 401(k) and Roth 401(k) because nobody knows how tax rates will change.